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U.S. Monetary Policy and the Financial Crisis
James R. Lothian1
Fordham University
Abstract: This paper reviews U.S. Federal Reserve policy prior to and during the
course of the recession that began in December 2007. It compares those policies to
monetary policy during the Great Depression of the 1930s with which this recession
has been likened. It then goes on to discuss what policymakers will need to do to in
the future to avoid a surge in inflation and the difficulties which they are apt to face
in implementing the necessary shift in policy.
JEL Classifications: E32, E51, E52, N12
Keywords: Macroeconomics, Money, Monetary policy, Business cycles, Great
Depression
1. Introduction
Richard Posner (2009) has written a new book entitled A Failure of Capitalism: The
Crisis of ’08 and the Descent into Depression. In viewing the 1930s debacle and the
current recession as similar, Posner is certainly not the odd man out. 2 As other
commentators have pointed out, both episodes are characterized by crises in the
financial system. Both have been preceded by substantial run-ups in asset prices.
Both have been worldwide in scope.
There are, however, fundamental differences between the two. One difference
should be obvious but often is ignored – the very much milder declines in real
income and increases in unemployment in the current episode than during the
1930s.3 A second which is less obvious but directly related to the first is monetary
policy. Here I focus in particular on money-supply behaviour. Doing so is
somewhat counter to the current emphasis on real interest rates and Taylor-type rules
as a gauges of monetary policy, but imposing that framework on analysis of policy in
1
James R. Lothian is Distinguished Professor of Finance at Fordham University, 113 West
60th Street, New York, NY 10023, USA, tel. 1 212 636-6147; fax 1 212 765-5573; emails
jrmlothian@aol.com lothian@fordham.edu . I would like to thank John Devereux, Cornelia
H. McCarthy and Gerald P. Dwyer, Jr. for their comments.
2
See, for example, Barry Eichengreen and Kevin H. O’Rourke (2009).
3
Real GNP from the cycle peak in 2007 fourth quarter to 2009 first quarter has declined 2.4
percent. During the comparable period in the Great Depression it declined 12.9 percent. The
U.S. unemployment rate in May 2009 was 9.4 percent. In 1931, it was 15.9 percent and two
years later reached close to 25 percent.
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Journal of Economic Asymmetries, Vol. 6 No. 2, September 2009, ISSN 1703-4949
26
The Journal of Economic Asymmetries
December 2009
the Depression era would not only be anachronistic but would lead to nonsensical
inferences.4
Unlike the Great Depression in which the money supply in the United States
plummeted in the wake of widespread bank failures, money supply in this episode
has continued to increase and in the course of this year has accelerated. The next
section of this paper documents this difference. It then discusses the role of policy in
the years preceding the current crisis. Here the data are more ambiguous, but point
to an overly excessively expansive policy on the part of the Federal Reserve as a
factor fueling the increase in housing prices prior to the onset of the current U.S.
recession. The paper concludes with a discussion of the dangers posed by the
Federal Reserve’s policy stance during the course of the period since late 2008, the
“exit strategy” that the Fed will need to pursue and the possible impediments to its
implementation.
2. Money in the Great Depression and the Current Recession
Figure 1 plots the logarithms of money supply for periods preceding and following
the respective NBER-defined business cycle peaks of August 1929 and December
2007. The point of reference in choosing the periods over which to plot the data is
the Great Depression, the 21 months from the previous cycle trough in November
1927 until August 1929 and the 43 months from then until the trough in March 1933.
The M2 series for the Depression is that of Milton Friedman and Anna J. Schwartz
(1970) and for the current recession that of the Federal Reserve. Figure 2 provides a
similar chart of the data for measures of the monetary base. The sources of these
data are Friedman and Schwartz (1963a) and the Federal Reserve Board. Figure 3
plots the ratio of M2 to the monetary base, the money multiplier, for the two periods.
The contrast between the behaviour of both M2 and the monetary base in
these two episodes is readily apparent from a glance at the charts. In the Depression,
M2 fell progressively, driven downward by three waves of banking panics and the
decreases in the public’s preferences for deposits relative to currency and of banks’
preferences for deposits relative to reserves that the panics engendered. Friedman
and Schwartz argued convincingly that this succession of monetary shocks and the
Federal Reserve’s failure to offset them is what made the 1930s depression “great.”
4
See the critique by Gandolfi and Lothian (1977) of one attempt to apply this framework to
the Great Depression.
Vol. 6 No. 3
Lothian: U.S. Monetary Policy and the Financial Crisis
27
Figure 1: M2 in Two Cycles
Ben Bernanke, the current Fed chairman, has expressed full agreement with
Friedman and Schwartz’s conclusions. In a paper (2002) that he delivered at a
conference honoring Milton Friedman on his ninetieth birthday, Bernanke stated:
“Let me end my talk by abusing slightly my status as an official representative of the
Federal Reserve. I would like to say to Milton and Anna: ‘Regarding the Great
Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do
it again.’ ”
Bernanke in this regard has been a man of his word. Whether he should have
demonstrated that by taking the particular actions that he has in this episode is
another question. Schwartz in a recent interview argues that he should not have, that
Bernanke has, in fact, greatly misjudged the nature of the crisis. “The Fed,”
Schwartz said, “has gone about as if the problem is a shortage of liquidity. That is
not the basic problem. The basic problem for the markets is that [uncertainty] that the
balance sheets of financial firms are credible.” (Carney, 2008).5
5
In this regard see Bordo (2009).
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The Journal of Economic Asymmetries
December 2009
Figure 2: The Monetary Base in Two Cycles
In any event, monetary policy, far from being contractionary, has been
expansive since December 2007 when the U.S. economy peaked and entered
recession. The money supply has increased by 11 percent, and with the base having
more than doubled since fall 2008, it is highly doubtful that M2’s course will
reverse. In the Great Depression, over the comparable period from August 1929 to
February 1931, M2 already had decreased by 5 percent, and that was before the onset
of the second wave of banking failures in October 1931. By the time the trough
finally was reached in March 1933, M2 had fallen by 33 percent.
The point is that there simply has been no monetary shock during the course
of this recession. That is very important. Historically, such shocks have been the
major factor producing severe contractions in the United States, as both Friedman
and Schwartz (1963a, 1963b) and Phillip Cagan (1965) have documented. Similar
evidence of the key role played by money supply in major cyclical fluctuations exists
for Britain and of a monetary transmission mechanism linking cyclical fluctuations
in that country with those in the United States (Huffman and Lothian, 1983). In this
regard, the Great Depression stands out in degree, but not in kind. Evidence for
milder cyclical declines in both countries is more mixed, with both real and
monetary factors appearing to play a role.
Vol. 6 No. 3
Lothian: U.S. Monetary Policy and the Financial Crisis
29
Figure 3: The Money Multiplier in Two Cycles
Now let us turn attention to two related developments that require comment.
The first is a comparison of movements in the money multiplier in the two episodes.
As Figure 3 shows, by April 2009, the latest month for which data are available, the
money multiplier already had fallen by as much as it did during the entire Great
Depression. The second is brought out in Figure 4 which plots quarterly data for the
income velocity of M2 in the two episodes. The paths followed by velocity up until
the same point in the respective cyclical appear very nearly identical.6
6
The quarterly data for nominal GNP in the two episodes are taken from Balke and Gordon
(1990) and the website of the Bureau of Economic Analysis of the U.S. Department of
Commerce, respectively.
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The Journal of Economic Asymmetries
December 2009
Figure 4: Velocity in Two Cycles
This steep decline in the money multiplier in recent months and its similarity
to the decline in the money multiplier during the course of the Great Depression, at
first glance, are unsettling. There is, however, less here than meets the eye. The two
declines, though similar in magnitude, are manifestations of two very different types
of underlying behaviour. In the Depression, the decline came after the fact, as
response to the banking failures. Individuals and businesses altered the mix between
their holdings of deposits and currency because of their distrust of banks. Banks,
faced with deposit drains, called in loans attempting to build up reserves. In the
current episode, in contrast, the decline appears to be the first-round result of the
massive injections of base money by the Fed. Bank deposits, and loans have
continued to grow, just not at anything close to the same extremely rapid pace as the
base.7
The genesis of the current decline in velocity could be due to either of two
things, or perhaps some combination of the two. On the one hand, it could be a
short-run transient phenomenon, produced in the first instance by the acceleration in
M2 growth and the inevitable lag before that monetary acceleration finds its way into
increased spending. That would be consistent with buffer-stock models of money
7
See Gavin (2009) for an analysis of the Federal Reserve’s balance sheet during the current
episode. He shows, among other things, that the bulk of the increase in the base has gone into
holdings of excess reserve by banks. Also see Thornton (2009).
Vol. 6 No. 3
Lothian: U.S. Monetary Policy and the Financial Crisis
31
demand (e.g., Carr and Darby, 1981) and other similar short-run monetary models
(Gandolfi and Lothian, 1983; Lothian, Darby and Tindall, 1990). Alternatively it
may reflect an increase in desired real money balances on the part of the public, the
result either of declines in the opportunity cost of holding money as interest rate have
fallen, or of increased uncertainty with regard to the economic outlook. An increase
resulting from uncertainty is somewhat more troubling, but not at all surprising,
given the unprecedented problems in the credit markets and the haphazard
government policy responses to them.
The severe decline in velocity during the course of the Great Depression and
associated increase in the public’s holdings of real money balances have been widely
described as the result of a liquidity trap. The basic notion here is that in situations in
which short-term interest rates are near zero, the demand for money balances
becomes metastable. Increases in the nominal stock of money, regardless of their
size, are willingly held and hence have no effect on spending, either nominal or real.
Monetary policy becomes impotent.
If it was the case the 1930s, could the United States be in the early stages of
such an episode now, as Paul Krugman (2008) argues?8 There are two very good
reasons to believe not. The first is empirical. The demand for money function did
not in fact change in such a way during the Great Depression or in the years
thereafter in which short-term interest rates continued to be low, contra the myths
and legends surrounding the Depression era. It remained stable: The evidence both
from studies using time-series data (Meltzer, 1963; Gandolfi and Lothian, 1977) and
from studies using cross-state panel data (Gandolfi, 1974; Gandolfi and Lothian,
1976) is quite clear in this regard. The second reason is theoretical. Underlying the
notion of the liquidity trap is a narrow view of the transmission mechanism for
monetary policy in which short-term credit instruments are the only substitute for
money. That, however, is completely unrealistic – the range of substitutes is much
broader, including other types of securities, real assets, non-durable goods and
services. Incipient excess supplies of money will result in a portfolio adjustment
process involving increases in nominal spending on this entire range of substitutes.9
8
Krugman writes: “Here’s one way to think about the liquidity trap — a situation in which
conventional monetary policy loses all traction. When short-term interest rates are close to
zero, open-market operations in which the central bank prints money and buys government
debt don’t do anything, because you’re just swapping one more or less zero-interest rate asset
for another. Alternatively, you can say that there’s no incentive to lend out any increase, in the
monetary base, because the interest rate you get isn’t enough to make it worth bothering. …
As of 10:38 this morning [March 17, 2008], the one-month Treasury rate was 0.57; the threemonth rate was 0.825. Are we there yet? Pretty close.”
Note that Krugman confuses two things here – effects on the demand for money and effects on
the supply of money. The concept of the liquidity trap only applies to the demand for money.
9
See Brunner and Meltzer (1963) and Friedman and Schwartz (1963b) and, for a more recent
discussion and interesting empirical evidence, Meltzer (2001).
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The Journal of Economic Asymmetries
December 2009
3. Monetary Policy Prior to the Cycle Peak
The question now to be addressed is the stance of policy in the years leading up to
the current crisis. Was it overly expansive and thus a precipitating factor in the
crisis? A number of commentators, arguing from rather different perspectives, have
claimed that it was. Some pointed to incipient problems before the event, though
writing when they did, could not have foreseen the details of what ultimately
transpired (Shadow Open Market Committee, Statements of April 15, 2002 and
November 10, 2003). Others, like John B. Taylor (2007, 2009) who have written
while the crisis has been underway and hence have had the advantage of a bit of
hindsight are more specific in their analyses.
The story that has now emerged is the following.10 At the heart of the
financial crisis – the sine qua non, if you will – were the subprime mortgages that
banks in the United States made at the urging of the U.S. Congress and that the
banks subsequently securitized. Much of this securitization took the form of
collateralized debt obligations (CDOs). Unlike the conventional residential
mortgage-backed bonds (RMBs) that banks had been issuing for several decades,
there was nothing “plain vanilla” about CDOs. CDOs are hybrid instruments –
heterogeneous and rather opaque combinations of RMBs of varying quality. They
are traded over the counter and they are much more difficult to value than RMBs.
When housing prices peaked and then began to fall, sometime between mid2006 and early 2007 depending upon the particular index, defaults on subprime
mortgages began to increase dramatically. This, in turn, had adverse effects on the
market for CDOs. Counterparty risk increased. Via a variety of channels, and as a
result of some of the policies subsequently pursued, the problems in the CDO market
spilled over to the rest of the U.S. credit market and to credit markets abroad. (See
Dwyer and Tkac, 2009).
What role did monetary policy play in the crisis? Figure 5 presents data on
the monthly rate of growth of M2 measured on a year-over-year basis and the
estimated monthly level of the real federal funds rate, alternative measures of the
Fed’s policy stance. The latter is defined as the nominal effective federal funds rate
minus the continuously compounded year-over-year rate of growth of the personal
consumption expenditure deflator. Table 1 presents averages of these data for
various subperiods.
10
In addition to Taylor (2009), see the detailed discussions of various aspects of the current
episode by Gerald P. Dwyer, Jr. and Paula Tkac (2009) and Michael T. Melvin and Mark P.
Taylor (2009) in papers presented at the conference on “The Global Financial Crisis: Causes,
Threats and Opportunities,” held at the Warwick Business School and co-sponsored the
Journal of International Money and Finance.
Vol. 6 No. 3
Lothian: U.S. Monetary Policy and the Financial Crisis
33
Table 1: Period Averages of the Real Federal Funds Rate and
Year-over-year Growth in M2
Period
2000
2001-2003
2004-2005
2006-2007
2008-2009
Real funds rate
M2 growth
3.78
-0.14
-0.47
2.34
-1.21
5.86
6.99
4.76
5.38
8.13
The stories told in the chart and the table by the two policy indicators are
largely, though not completely, the same. For most of the period, the two provide
similar readings of Fed policy. Viewed on the basis either of M2 growth or the level
of the real federal funds, monetary policy was clearly quite expansive in 2001-2003,
Figure 5: The Real Federal Funds Rate and M2 Growth
was more restrictive in both 2000 and in 2006-2007, and turned more expansive
again in 2008 and 2009. The one period in which the two measures differed as
gauges of policy was 2004-2005. The real funds rate on average was negative,
34
The Journal of Economic Asymmetries
December 2009
suggesting substantial monetary ease, while M2 growth was relatively restrained 4.8
percent per annum on average.
Maintained over the longer run, such a rate of M2 growth normally would be
consistent with roughly the same rate of growth of nominal income and, given a
long-run rate of real income growth of three percent per annum or more, a two
percent or lower rate of inflation. The -.5 percent average level of the real federal
funds rate, in contrast, implies a much higher average rate of inflation. That, in any
event, is the story told by the Taylor-Rule equations. We can see this clearly in
Figure 6, which is taken from the June 2009 issue of Monetary Trends published by
the Federal Reserve Bank of St. Louis. Shown in that chart are plots of the actual
nominal federal funds rate and the implied federal funds rates for target inflation
rates, ranging from 0 to 4 percent per annum over the period 2000 to the present.
The calculations in the chart are based on the following equation:
R*t = 2.5 + πt –1 + .5 (πt –1–π*) + .5 [100 x (y t–1 – y* t –1)],
(1)
where R*t is the implied federal funds rate; πt –1 is the year-over-year inflation rate
in the previous period as measured by the personal consumption expenditures price
index; π* is the target inflation rate; y t–1 is the log of the real gross domestic
product in the rate in the previous period; and y* t –1 is the log of an estimated level
of potential output in the previous period.
Figure 6:
Source: Monetary Trends, Federal Reserve Bank of St. Louis, June 2009.
Using that equation, the data in Table 1 and assuming that actual and
potential output are equal, which was approximately the case in 2004-2005, we can
derive a point estimate of the average rate of inflation in that period. This works out
to be just under 6 percent per annum.
The actual inflation rate, however, averaged 2.8 percent per annum, roughly
three percentage points lower than the Taylor Rule would imply and a percentage
point or more higher than M2 growth would imply. Neither policy measure,
therefore, accurately depicts the average behaviour of prices during this two-year
Vol. 6 No. 3
Lothian: U.S. Monetary Policy and the Financial Crisis
35
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